Managing Equity Dilution from Convertible Notes

Raising startup capital by issuing convertible notes to early investors is a great way to get money in the door quickly. The great benefit is that most of the difficult negotiation gets kicked down the field a ways to the hoped for institutional round of venture financing. But can you really defer all those uncomfortable conversations? And what happens if you don’t think you’ll need an institutional round of financing? Do you need to add some detail now to the terms on which the notes will convert?

If you don’t think you’ll need a second or add-on rounds of financing, then you do need to figure out a way for the notes to convert into equity, and what that really means is you and the purchasers of the convertible notes will need to agree on a valuation of your company in order to determine a price per share at which the notes will convert to shares (i.e. by dividing principal/interest by the share price to determine number of shares).

You can either have the valuation discussion now and bake into the notes a term that establishes the valuation at which the notes will convert in, say, 24 months. Or, you can punt on the issue right now and simply state that unless another financing event has occurred before the maturity date (e.g. 24 months), the notes will convert into shares at a valuation to be determined at the time of conversion.

There are risks to doing it either way, and as the founder you’re in the position to drive the conversation. If you think you’re in a strong negotiating place now, then you might push to set the valuation now–and set it on the high side of where you think you’ll be when the notes mature. If you’re hungry for the money now but think you’ll be in a stronger position down the road, then you might delay the conversation.

Ultimately, the higher the valuation, the fewer shares the noteholders get for their money and the less dilutive it is to the rest of the stockholders.

All that said, the one of the great things about doing a round of institutional equity financing after the convertible notes is that a third party ends up setting the valuation–namely the investors in the Series Seed or Series A round–and typically angel investors will defer to that. So if there’s a good chance you’ll do another round of financing it may be more expedient–and easier on your relationship with these early investors–to let a third party decide the valuation down the road.

Whatever you decide, remember that the goal is to build a company, not get bogged down in detailed finance negotiations. So keep it simple and get the money in the door without giving away the keys to the kingdom.